Preparing for IFRS 17: Choosing the right capital levers

Dutch Insurance Outlook 2018

In May 2017, the IASB published IFRS 17 Insurance Contracts. This means that life insurers have to make important changes when it comes to accounting. In this article we tap into the difference between Solvency II and IFRS 17, capital levers that should be considered, and suggested ways of choosing and implementing the right capital optimisation strategy.

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For lack of a better alternative, Solvency II has quickly gained a foothold among financial analysts and investors. The Solvency capital ratio and the potential ‘capital generation’ have become important indicators for assessing a European insurer’s financial situation. For now, Solvency II measures are considered uniform and reliable, and therefore they are more important indicators than IFRS 17 when comparing the performance of different insurance companies.

Comparing insurance companies’ insurance liabilities and profit figures as reported under IFRS 17 is a futile exercise. The reason is that IFRS 4, the current accounting standard that deals with insurance contracts, is an interim standard that allows the application of any other accounting framework for the measurement of insurance liabilities. Even insurance companies that operate in the same country may apply different measurement principles: some use Dutch accounting principles, others US accounting principles, under IFRS 4, anything goes. This makes comparing insurance liabilities an impossible task. And as insurance liabilities drive gains and losses, IFRS profits are also hard to compare.

This may be about to change. In May 2017, after a lengthy standard-setting process, the IASB published IFRS 17 Insurance Contracts. No longer will insurers be able to apply a wide range of accounting principles for their insurance liabilities. Instead, IFRS 17 introduces clear and consistent accounting rules that will improve the comparability of financial statements. No longer will insurance companies be able to use the accounting framework of their choice. IFRS 17 will likely become effective in the EU for financial periods commencing after 1 January 2021, which means that a full IFRS 17 opening balance sheet will be required for the financial year starting 1 January 2020.

Dutch Insurance Outlook 2018

Solvency II is less suitable for measuring future performance

Despite the current popularity of Solvency II measures among market participants, the aim of Solvency II is not to reflect the insurance company’s current and future financial situations. Instead, the aim is to determine the capital an insurance company should hold to reduce the risk of insolvency. Under Solvency, technical reserves are also based on best estimate assumptions, just like under IFRS 17, but the framework is aimed at prudency. So an insurer can be prudent, for example by applying simplified models or by adding extra capital buffers. Supervisory authorities won’t object if the insurer reports more conservative figures, if this results in holding more capital than minimally required. Investors, however, want to be able to compare the financial state and future profitability of different insurers, which is impossible if insurers apply different levels of prudency.

IFRS 17, by contrast, does not allow the application of prudency. Reported figures should always be a ‘best estimate’. So, although Solvency II reporting will still be relevant for investors, IFRS 17 allows for better comparison and provides an improved indication of future profitability. Once IFRS 17 is fully adopted and understood by investors, the expectation is that they will rely more on IFRS 17 and less on Solvency II and on Market Consistent Embedded Value (‘MCEV’).

Insurers should consider the effect of Solvency II capital levers on the 2021 IFRS figures

When insurance companies publish IFRS 17 figures for the first time—in the financial statements over 2021 (with comparative figures for the year 2020)—financial analysts and investors will display a more-than-average interest in these figures. It is therefore important to take the effect of the insurance company’s asset and liability portfolios on the 2021 reported figures into consideration. Given the current capital strategies, will the insurer be able to show profitable growth in the years following the implementation of IFRS 17? There are measures that should already be implemented now, for them to be in time to affect those 2021 financial statements.

The impact of IFRS 17 on non-life insurance contracts is expected to be limited, as non-life insurance is generally short-tail. IFRS 17 will have the largest impact on the accounting for life insurance contracts and, therefore, the capital levers discussed will apply mainly to life insurers.

Some of the capital levers that can be considered are:
Using the matching adjustment: The ‘matching adjustment’ is a mechanism that prevents changes in the value of assets, caused by spread movements, from impacting companies’ Solvency II balance sheets for portfolios where companies have mitigated the impact of these movements. This mechanism can be applied if the insurance company holds assets until maturity, such as mortgages. Approval from the supervisor has to be obtained before it can be used.

Under Solvency II, this capital optimisation strategy can release capital, but in practice it has proven difficult to implement. However, for IFRS 17, this mechanism has even more benefits. Under IFRS 17, a discount curve is calculated to discount insurance liabilities. If matching adjustment is applied, and several other criteria are met, this could result in a more favourable discount curve under IFRS 17, and hence in an opportunity to manage future profits.

Selling off onerous contracts (such as closed-book life portfolios): This will lead to a one-off Solvency II liquidity inflow, and will eliminate the need to report a one-off loss on the IFRS 17 opening balance sheet. The onerous contracts will have to be sold at a discount, and any loss will have to be shown in the IFRS accounts. But from a timing perspective, it may be beneficial to show such a loss before the implementation of IFRS 17. Another advantage of such a sale is that calculating the required parameters for these portfolios under IFRS 17 can be avoided—potentially a very costly exercise.

Selling off non-core strategic activities: IFRS 17 should not be the main driver for following this strategy, but capital optimisation considerations may play a role when considering this course of action. This will lead to a one-off Solvency II liquidity inflow. The IFRS 17 impact will be limited.

Selling off selected assets and implementing an optimised Strategic Asset Allocation: If done right, this strategy will increase mid to long-term profitability, while decreasing required Solvency II capital. Under IFRS 17, this will increase mid to long-term profitability.

Mitigating longevity and mass lapse risk: Using reinsurance contracts, this strategy will reduce the required Solvency II capital, but may increase volatility in the IFRS 17 financial statements.

Changing the interest rate hedging strategy to a Solvency II ratio hedge: Instead of hedging individual asset or liability portfolios, a more holistic hedging strategy is applied that ensures the Solvency II ratio doesn’t fluctuate as much when interest rates change. This strategy will decrease Solvency II ratio volatility. The effect under IFRS 17 can be either positive or negative. The results after implementation of IFRS 17 (and, as this concerns hedging, also IFRS 9) would need to be assessed.

Now is the time to assess and then implement the optimal capital levers

In order to choose the optimal capital optimisation strategy, and maximise profitable growth once IFRS 17 is implemented, we have the following recommendations:

Start in time: the 2021 financial statements will include comparatives for the year 2020, so the appropriate measures should be in place before 1 January 2020. Some of the preparatory measures may take time to analyse, agree upon and implement.

Be creative in considering the possible capital optimisation strategies.

Take a holistic approach: look at the effect of capital optimisation strategies on assets, on liabilities, and on the insurance company as a whole. Don’t forget the banking activities that may be undertaken with the insurer.

Leverage the experience gained during the Solvency II implementation.

Now more than ever, it’s crucial to have Risk and Finance work together closely, to assess the impact of capital optimisation strategies, both under Solvency II and under IFRS 17.

Dutch Insurance Outlook 2018

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